01—Abstract
Summary
Summary of the 10-K filed February 28, 2007. Cited figures are marked; the original filing is the authoritative source.
Progressive (PGR) closed 2006 with net income of $1.65 billiona, or $2.10 per diluted share, up 18% from $1.39 billion in 2005, on total revenues of $14.79 billion.
The result was driven by strong underwriting profitability: the total underwriting combined ratio was 86.7 (13.3% underwriting margin), improved from 88.1 in 2005, despite net premiums written growing only 1% to $14.13 billionb. Favorable prior-year loss reserve development contributed 1.7 points to the combined ratio, and catastrophe losses were light (0.5 points versus 2.4 in 2005). Management described the year as 'good, but not great,' citing slow premium growth, falling policies in force in Personal Lines (up only 3%), and a deliberate shift toward rate reductions to win back retention.
Capital management was the other major theme. Progressive repurchased 39.1 million shares for $1.2 billionc, paid only $25 million in regular dividends, and retired its $100 million 7.30% notes. Its debt-to-total-capital ratio fell to 14.8%, and the premiums-to-surplus ratio was 2.8 to 1.
Management also announced that beginning with the 2007 dividend, it will replace the nominal fixed dividend with an annual variable dividend equal to 20% of after-tax underwriting profit, multiplied by a Gainshare factor ranging from zero to two. Applied to 2006, that formula would have produced roughly $0.39d per share, or about $292 million. The main risks for investors are a softening auto market with rising competitor advertising and rate cutting, a slowing rate of premium growth, dependence on continued favorable reserve development, and regulatory and litigation exposure, including a $61 million jury verdict in February 2007 that the company says will be reduced to the $300,000 statutory cap.
02—Key points
Key Highlights
- Net income of $1.65 billion ($2.10 diluted EPS) rose 18% year over year, on total revenues of $14.79 billion.
- Underwriting combined ratio improved to 86.7 from 88.1 in 2005, a 13.3% underwriting margin, with the Personal Lines combined ratio at 87.7 and Commercial Auto at 80.2.
- Net premiums written grew only 1% to $14.13 billion, reflecting soft market conditions, a 2.8% decline in average earned premium per application, and a 7% drop in new Personal Lines applications.
- Favorable prior-year reserve development of $246.9 million contributed 1.7 points to the combined ratio, down from 2.6 points in 2005.
- Repurchased 39.1 million shares for $1.2 billion at an average of $24.98 per share (split-adjusted) and paid only $25 million in regular dividends.
- Board replaced the fixed dividend with an annual variable dividend starting in 2007, set at 20% of after-tax underwriting profit times a Gainshare factor of 0 to 2; the 2006 equivalent would have been about $0.39 per share.
- Debt-to-total-capital fell to 14.8% (from 17.4%), and the net premiums written-to-surplus ratio was 2.8 to 1; the investment portfolio totaled $14.7 billion, with a fixed-income weighted average credit quality of AA+.
03—Questions
Frequently Asked Questions
Why did Progressive's earnings grow 18% when premium growth was nearly flat?
Earnings growth came mainly from better underwriting margins. The combined ratio improved 1.4 points to 86.7, catastrophe losses were far lighter than in 2005 (0.5 points versus 2.4), and favorable prior-year reserve development added 1.7 points. Investment income also rose 21% to $638.1 million on higher yields.
What is the new variable dividend policy and how much could it pay?
Starting with the 2007 dividend, Progressive will pay an annual dividend equal to 20% of after-tax underwriting profit (for 2007), multiplied by a Gainshare factor from zero to two. Applied to 2006 results with a 1.18 Gainshare factor, the formula would have produced about $0.39 per share, or roughly $291.7 million, compared with $25.0 million actually paid in 2006. The company says it cannot predict the 2007 amount.
Are there signs of pressure on Progressive's core auto business?
Yes. Management reported slowing growth in premiums and policies in force, rate cutting by competitors, higher advertising and agent commissions, and weaker retention. Personal Lines policies in force grew just 3%, versus 9% in 2005. Progressive began reducing rates in late 2006 to trade margin for retention, and its management has set a 96 combined ratio target while acknowledging that margins may decline.
How large is the reserve cushion, and is there a risk of adverse development?
Net loss and LAE reserves were $5.4 billion at year-end 2006, including $1.2 billion of IBNR. The company has reported favorable development for several consecutive years. The filing's sensitivity analysis shows that each one-point change in accident-year 2006 severity would move personal auto liability reserves by about $50.7 million and commercial auto liability reserves by about $8.4 million. Management acknowledges that severity trends may normalize, with personal auto liability severity expected to rise in the 4% to 6% range.
What legal or regulatory issues could affect Progressive?
Progressive faces numerous putative class actions covering issues such as aftermarket parts, credit-based underwriting under the Fair Credit Reporting Act, total-loss valuation, and PIP and medical claim practices. It also received document requests from several state attorneys general about possible bid-rigging and contingent commissions. A February 2007 Oklahoma jury awarded $61 million in a Title VII employment case; because federal law caps compensatory and punitive damages at $300,000 in such cases, management believes the verdict will be reduced and that any material impact is unlikely.
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